Peak Oil News: Why Oil May Hit $100 a Barrel

Monday, May 08, 2006

Why Oil May Hit $100 a Barrel


Will We Hit $100? Such forecasts, once the province of the enviro-fringe, now come from the likes of Goldman Sachs. Here's why.

By Karen Lowry Miller

The first oil shock of the 21st century is now upon us, even if it has not (yet) hit the global economy. This time, the early fallout is measured in largely political terms—in the growing cockiness of oil states like Venezuela, the defiance of Iran, the expansion of state oil companies from producing nations like Russia, the backlash against hugely profitable oil giants and the near desperation of incumbent politicians in consuming nations like the United States and Germany. In recent weeks, as the price of oil passed $70 a barrel, the price of gas topped $3 a gallon in the United States and ex-oilman George W. Bush unleashed an investigation into possible price manipulation by Big Oil, the old power relations of our oil-based world were clearly being turned upside down.

It may be only a matter of time before the economic shock arrives. Predictions that a $10 hike in the price per barrel of oil would shave half a point off world growth rates have yet to pan out, but that doesn't mean they won't. Our happy surprise that global growth has yet to slow misses the catch: if the economy can run with a $70-a-barrel burden on its back, the price is less likely to fall. More and more companies are tacking on fuel surcharges, and the specter of petrol-fueled inflation is rearing its ugly head.

Worse, there is an increasingly strong case, perhaps even an emerging consensus, that we are heading for a new price reality—one that until now has been the province of oil-conspiracy crackpots and environmental end-of-timers. This is the world of $100 oil. Goldman Sachs analysts Arjun Murti and Brian Singer surprised the markets in March 2005, when prices hovered at about $47 a barrel, by predicting a "superspike" that would drive oil up from $50 to as high as $105—and suggesting prices could remain there for five to 10 years. Now predicting $100 oil has become respectable. Just look at the futures market, where call options on $100 barrels—a novelty when the first one appeared last year—are now commonplace.

The reason the new spate of forecasts is so scarily convincing is because they don't rely upon sweeping but unprovable claims that the world is running out of oil. This has been the case put forward for years by "peak oil" theorists, who say today's prices are a symptom of the fact that we have found all the oil we can pump economically, so it's all downhill for supply. Since no one has found a way to X-ray the planet to determine exactly how much oil is left, peak-oil theory is based in part on faith in pessimistic geology. Oil bulls respond with their own article of faith: that there is oil down there, and improving technology can and will find it.

Some of the most worried analysts now assume that the bulls are right: there is plenty of oil in the earth. But technology alone can't solve the problem—not soon, anyway—if the industry is not deploying it. "Peak oil is a red herring," says Barclays Capital analyst Paul Horsnell. "It's all about fundamentals." The problem is that the major oil-producing nations have not spent enough—and don't plan to spend enough—to meet rising demand, particularly from the United States and China, in the near to medium term. Spooked by past episodes of overspending in boom times, companies have chosen to sit on their cash, or return it to shareholders, rather than build new production or refining facilities. Ultimately, Singer and Murti argue, oil is still a cyclical commodity (not a vanishing resource), and prices will fall back to earth. But they expect an extended period of high prices that could last through 2009 before tapering off through 2014. And already, gas lines have reappeared in the United States, as consumers hunt for the cheapest pump prices.

History suggests that the current fundamentals look a lot like the 1970s. Goldman Sachs research shows that oil prices tend to spike during periods when oil states and companies are investing, then fall as that spending produces new supplies (charts). Thus, prices shot up as investment rose in the late ' 70s, then fell as that investment yielded a new cushion of spare capacity in the 1980s. The price slump that followed lasted through the late 1990s, depressing investment in oil while the broader market funneled money into the tech stars of the New Economy. Over the past 20 years, spare production capacity has fallen from 15 percent to barely more than 1 percent worldwide, with no immediate prospect of relief. Goldman Sachs analyst Jeffrey Currie calculates that the oil industry needs to invest a stunning $3.5 trillion over the next decade just to keep up with rising demand. "We call it the revenge of the Old Economy," says Currie.

If anything, the uncertainties surrounding global oil investment are even higher today than in the 1970s. "When you have no margin for error, Murphy's Law kicks in and anything that can go wrong will," says independent oil consultant Lowell Feld. If a confrontation with Iran were to cut off its 2.5 million barrels of exports per day, "there is no one else to make up the slack," says Feld. Deutsche Bank analyst Adam Sieminski argues that a supply cut of 2 million barrels a day would be enough to drive prices to $100. Global Insight chief economist Nariman Behravesh goes further: "All it takes is a single geopolitical event, such as an attack on Iran, to trigger a major shortage and even $120 oil."

This situation is the result of a quarter century of underinvestment in oil supply. Since it takes up to seven years for oil investments to yield actual oil, even a crash spending program now wouldn't prevent a superspike. Consider just five of the top 10 oil producers, who together control more than half the world's reserves. The largest reserves are in Saudi Arabia, which accounts for nearly all of today's spare capacity and remains relatively stable, despite recent terror attacks on oil installations. It plans to invest billions to raise its daily output from 9.6 million to 12.5 million barrels by 2009.

The rest of the five are all treading water, or worse. The second largest con-ventional reserves are in Iran, which produces less today than it did 30 years ago, and is having trouble attracting multinational investors, who are spooked by its defiant pursuit of a nuclear-energy program. In Iraq, where oil production plummeted after the 2003 invasion, insurgents attack oil facilities once every three days, on average. No surprise, investors are staying away. In Russia, oil investment boomed after the fall of the Soviet Union but has leveled off since. Gennadiy Shmal, president of the Russian Union of Oil and Gas Industrialists, has publicly criticized the Kremlin for spending too little on exploration.

Meanwhile, Venezuela has seen production from its state-owned firm drop 50 percent since 2003 under the radical populist Hugo Ch�vez, even as he runs foreign investors out of the country. Ch�vez claims grand plans to spend $56 billion by 2012 on new production and refineries, but analysts are skeptical about his priorities. Columbia University's Adam Louis Shrier says Ch�vez "uses oil as a political tool" to advance his social agenda: hospitals, schools, vacation homes for employees. "The national company is not about oil or economic performance," he says.

While oil investment is picking up again, there are reasons to suspect that this cycle will see less money spent more slowly than in the past. One big reason is politics, and not only in Venezuela. Oil-producing nations from the Middle East to Russia are raising the government share of oil revenue to fund the welfare programs that keep reigning princes and populists in power. Social spending is on the rise at a time when tapping old and remote fields is increasingly complex, and expensive. Those costs have also risen because many skilled workers left the industry during the long investment slump.

Social welfare competes for oil dollars throughout the Middle East, one of the few regions where populations are still growing fast. As the number of young people entering the Saudi work force surges, the Saudis need a minimum oil price of $40 to $50 to maintain their current system of subsidies for food, housing, education and employment, says Feld. New Iranian President Mahmoud Ahmadinejad has also promised oil money to fund social programs, and Russian President Vladimir Putin has pledged that oil profits will be used to fight poverty in Russia. All of that siphons off money that could be used to increase oil production.

It also scares off Big Oil, which is sitting on piles of cash but faces a perilous investment climate. To fund his social schemes, Ch�vez has raised the income tax charged to foreign oil companies from 34 percent to 50 percent, and roughly doubled the cost of royalties to 30 percent; last month he seized an oilfield outright from the French firm Total and broke a contract with Eni of Italy. Taxes are so high in Russia, says Currie, that oil has to reach $80 a barrel for multinationals to make a 15 percent return on capital.

In some ways, international oil companies have undermined their own incentives to invest, in part by failing to see which way prices were going. Up until 2003 they based investment decisions on projected prices of about $15 a barrel, says Columbia University's Shrier. Indeed, many were so confident that oil would never top $30 a barrel that they agreed, in West Africa for example, to pay graduated taxes that reached 100 percent at oil prices above $30. Shrier estimates that oil companies have raised long-term price estimates to about $35 a barrel, representing "a fundamental change" in the industry that should open the doors for investment in the future. But it can't come soon enough to slow the pace of a superspike that may already have begun.


At 10:02 PM, May 08, 2006, Blogger Chan Chan said...

Yes, I believe $100.00 oil is possible.

-JChan Atomic Motor - Cold Fusion Energy Blog

At 5:07 AM, May 10, 2006, Anonymous Anonymous said...

Actually, we do know about how much oil is left in the earth. It's not an article of faith that the world is running out of oil. "Pessimistic geology" (otherwise known as geology) has been used to find almost all the important oil deposits over the last century, and despite untold billions spent on exploration, there is not enough oil found to replace what is being used.

Yes, Karen Lowry Miller, the world is running out of oil, and all the faith-based assumptions of Wall Street analysts can't change that fact.

At 11:21 AM, May 11, 2006, Anonymous Anonymous said...

"...Chavez "uses oil as a political tool" to advance his social agenda: hospitals, schools, vacation homes for employees. "The national company is not about oil or economic performance," he says."

That says it all about the priorities of the system status quo. Schools? Hospitals? How dare they! Why, they should be injecting more cash into the world markets! What are our poor speculators going to do with themselves?

Might as well build schools and hospitals while they have the cash. Maintaining them, if they are connected to their communities, will hopefully be possible.

At 9:14 AM, May 18, 2006, Anonymous Anonymous said...

Perhaps a more accurate term would be - Peak "Cheap" Oil.
It matters little how much oil is actually left, if this fossil fuel's price climbs into the stratosphere and stays there.
Currently much of the planet's business relies heavily on cheap fuel for gobalized transportation.
It also factors into the 1300 mile Caesar salad, the 4,000 sq. ft. McMansion, and the 50+ mile commute. (not to mention the 100+ miles a day soccer-mom lifestyle.)

Somehow I don't see much of Europe wanting to adopt American consumption patterns...they've gone without long enough to accept viable alternatives.

However, with a third of the Earth's population waiting to jump on board (China and India) things could heat up considerably - metaphorically and literally.
If 10% of all households in India and China became middle class American-style consumers, this would total all the households in that category in both the US and Canada (and throw in Mexico's smidgeon as well.)
Now that's an alarming thought.

Rising fuel costs will drive prices up. Something to consider also is the amount of fossils used in manufacturing - in particular, plastics.
The more consumers spend on fuel, the less they have to spend on everything else.
The majority of North Americans live a driver-dependent lifestyle.
The results should be obvious. In an oil economy, cheap oil is mandatory to make it work.
Consider the consequences: If gas rises to $8 a gallon or more, people will still buy it (they'll have little choice.)
However, many will stop spending all the mad money currently devoted to consumption of trinkets, infotainment, status-conscious electronic toys, designer clothing, fast food, and a whole host of other non-essentials.
That soccer mom still has to run errands and commute, no matter what. Compared to this kind of essential, many other non-essentials can fall by the wayside.
The ultimate results of all this would, I imagine - be the mother of all recessions.

At 9:21 AM, June 02, 2006, Anonymous Anonymous said...

I don't know if it will hit $100, but I definitely believe $60+ will be sustained for the next 10 yrs. Very good points presented and excellently thought out. I package oil investments for field development in the U.S. and I can tell you that there is alot of oil (though not enough to self-sustain us) that is still sitting out in the states due to non-exploration/non-development. Its good times for oil investors in the states, not so much for the consumer. - oil investments in Texas.


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